When selling a capital asset, it is critical to include the tax consequences of the transaction in the decision making process. Three taxes are typically triggered when a capital asset is sold including federal and state capital gain and recaptured depreciation. These taxes can represent upwards of 40% of the sales price and more if the asset is held less than one year. Such states as Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington and Wyoming do not have a state capital gains tax but federal capital gain and recaptured depreciation taxes will still apply to the sale. A 1031 exchange allows deferring the above-mentioned taxes until the sale of the replacement property.
Benefits and Risks
1031 exchanges can be initiated over and over, effectively deferring to your beneficiaries at death. Given our country’s debt issue, raising taxes will most likely be a part of the long term solution. The risk is whether the property acquired will appreciate and generate adequate income to exceed a higher capital gains rate.
Currently, the federal long-term capital gain tax rate on real property for taxpayers in the 25, 28, 33 and 35 percent brackets is 15%. Long-term capital gains is the federal income tax on assets held for one year and a day while short-term capital gains tax rate is the taxpayer’s ordinary income tax rate. Taxpayers in the 10 and 15 percent brackets pay 5% on long-term capital gains.
Effective January 1, 2013, the federal capital gains rate is scheduled to increase to 20%. An additional 3.8 percent Medicare tax will apply to those with an adjusted gross income exceeding $200,000 for single and $250,000 for married filing jointly taxpayers.
Example: When Benefits Outweigh Potential Risks
A married couple filing a joint return, has an adjusted gross income above $69,000 (in a 25-percent income bracket):
- They sell a rental property purchased for $200,000 for a sales price of $400,000. This triggers a realized gain of $180,000 and capital gains and depreciation tax of $35,120 in 2012.
- In a 1031 exchange, the gain of $180,000 is deferred by acquiring a property of equal or greater value. The new property is purchased for $400,000 and later sold for $500,000 after a year or more.
- The property’s basis is reduced by the $180,000 realized gain of the first property and the replacement property sale results in a realized gain of $278,000 or capital gains and depreciation tax of $65,552.
The 1031 exchange represents an interest free loan of $35,120, with the return on the investment appreciating at 3.0 percent or $1,053 per year. The return is woefully smaller than the $13,400 tax resulting from the higher capital gains tax. However, if the taxpayer wants to acquire a replacement property to continue deferring the gain, the exchange will be beneficial, given the longer the property is held, the more likely it is to justify deferring the higher capital gains tax with another 1031 exchange. If the taxpayer does not want to acquire another property, then it may make sense to pay the historically low federal capital gains tax of 15% along with the recaptured depreciation tax.
Deferred Sales Trust
Another option is a Deferred Sales Trust to defer the capital gain and depreciation taxes. Deferred Sales Trusts can defer the gain on primary residences above the Section 121 $250,000 and $500,000 exclusion and on highly appreciated second homes.
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General word to the public. Be careful! I lost my entire life savings in a 1031 exchange. I was now alone. Numerous people who had worked their entire lives building equity in a property had everything stolen from them. 1031 exchanges are not regulated by the feds and are only as trustworthy as the people managing them! Be careful!
Hello Sam, Caution, beware is right. Defalcations have not been limited to the tenant-in-common replacement properties that were once popular during 2005 – 2007, or the rogue Intermediary that did not provide adequate escrow account safeguards. Be sure to use qualified escrow accounts that require the taxpayer’s signature that matches the notarized signature on file at bank along with the intermediary’s to authorize disbursements. Use a Qualified Intermediary (QI) that is a member of the Federation of Exchange Accommodators who require an annual criminal background check on the intermediary principal responsible for handling client funds. Use a QI that states in the exchange agreement that the exchange funds “shall not be deemed a part of the QI’s general assets or subject to claims of QI’s creditors” and uses non commingled escrow accounts. The Dodd Frank Wall Street Reform and Consumer Protection Act of 2010 creates the Bureau of Consumer Financial Protection within the Federal Reserve. The law requires the Bureau to conduct a study and propose legislation to protect consumers engaging Qualified Intermediaries accommodating 1031 tax deferred exchanges. The proposed recommendations are to be completed one year after the law takes effect and implement regulations within two years of the Bureau’s report. Finally, trust but verify, ask what options are available from your QI to protect your funds.